Bank Recapitalization in India

The Indian banking system is almost facing an existential crisis. Even though the economy of India seems to be growing at a brisk pace, the banks are under severe duress. This is the case, especially with public sector banks. It is alleged that big industrial houses have been able to siphon off trillions of rupees from these banks. Many of these bank officials accepted kickbacks and gave out massive loans to corporations which were already overleveraged. The resultant situation has created systemic risks in Indias banking system. The government is now intervening to prevent the banks from what looks like an inevitable collapse. In this article, we will understand the nonperforming asset (NPA) crisis that India is going through as well as the bank recapitalization process that is being undertaken by the government to avert this crisis

Twin Balance Sheet Problem

Let us begin by understanding the problems that are being faced by India banks. Firstly, the government introduced demonetization in 2016. As a result, there are excess deposits in most Indian banks. It is estimated that more than 4 trillion rupees have flown into Indian banks after demonetization took place.

The problem is that these deposits are liabilities of the banks. Hence, banks have to pay interest on these huge deposits. Ideally, banks invest their deposits by loaning them to individuals or corporations. However, India is facing a twin balance sheet problem which is preventing this from happening.

Firstly, the banks in India are under severe duress because of the bad loans that they have made in the past. This is evident from the fact that banks in India are holding close to 10% non-performing assets. This is way above the global norms. The private sector banks have performed better. However, if only the public sector banks are considered, they are holding anywhere between 16% and 24% of non-performing assets. The bigger problem is that more than 86% of these non-performing loans were made to institutional borrowers. Companies with a net worth of more than 500 crores account for more than 86% of the bad loans.

The same thing can be said about Indian corporations as well. Most Indian corporations that are listed on the stock exchange are saddled with excessive debt. Hence, there isnt much room for the banks to push their loans.

NPAs and Liquidity Crunch

The problem with these non-performing assets is that they are creating a liquidity crunch in Indias banking system. Most Indian banks are now saddles with these assets. As a result, they are wary of lending money to corporations. On the other hand, corporates are also skeptical of borrowing even though the interest rates are at an all-time low. This is creating a sort of liquidity crunch. The rate of credit growth has become very slow. As a result, industrial output is declining and the GDP of the nation is taking a hit.

Write-Offs and Capital Provisions

As per Basel norms, banks have to write down the loans that they know are not going to be collectible in the near future. This amount reduces the amount of equity or capital that banks have. The same Basel norms also stipulate that banks must maintain a ratio between the number of loans that they make and the amount of capital that they have on hand. It is rumored that if Indian banks follow these procedures, more than 11 of the public sector banks will not have enough capital to meet the Basel norms. This will threaten the continuation of their business as a going concern. It is for this reason that there is an urgent need to recapitalize Indian banks.

What Is Recapitalization of Banks?

Finance Minister Arun Jaitley has proposed that recapitalization bonds need to be issued to help the banks become Basel complaint once again. The following steps will have to be undertaken to accomplish the task of bank recapitalization.

Firstly, the government of India will issue bank recapitalization bonds. Only banks will be allowed to buy these bonds from the market. Hence, in essence, the government of India is borrowing money from these banks

Banks will be asked to use the excess deposits from demonetization to buy these bonds. Hence, banks will no longer have to worry about paying interest on those deposits. The interest received from the government will be passed on to the savings bank account holders.

Lastly, the government will use the money accumulated by bond sales to buy equity at the banks. This will infuse more capital in these banks and make them Basel compliant.

This solution will meet both the needs of the Indian banking system. Firstly the systemic risk will no longer be present. Secondly banks will not have to worry about making bad investments to deploy the funds raised as a result of demonetization.

Future Bad Behavior

The problem with this approach is that the Indian government is penalizing the banks which have performed well. They are implicitly rewarding the bad performing banks. The end result is that the businessmen and corrupt bank officials have siphoned huge sums of public money and have left taxpayers to pick up the bill. This will obviously set a bad precedent and will encourage more corruption once banks are recapitalized and capable of making big loans once again.

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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.

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